Proud of What?

Why the Federal Reserve and other central banks shouldn't brag about their response to the Great Recession.

It is increasingly common to hear prominent American and European central bankers proclaim this verdict for themselves with respect to the crisis of 2008-10. Their view is that the various government actions to support the financial system helped to stabilize the situation. Indeed, what could be wrong when the Federal Reserve's asset purchases may have actually made money (which is then turned over to the Treasury Department)?

To frame the issue in this way is, at best, to engage in delusion. At worst, it creates an image of arrogance that can only undermine the credibility on which central banks' authority rests.

The real cost of the crisis is not measured by the profit-and-loss statement of any central bank—or by whether or not the Troubled Asset Relief Program (TARP), run by the Treasury Department, made or lost money on its various activities. The cost is 8 million jobs in the United States alone, with employment falling 6 percent from its peak and—in a major departure from other post-1945 recessions—remaining 5 percent below that peak today, 31 months after the crisis broke in earnest. The cost is also the increase in net federal government debt held by the private sector—the most accurate measure of true government indebtedness. Comparing the Congressional Budget Office's medium-term forecasts before (in January 2008) and after the crisis, this debt increase is a staggering 40 percent of GDP.

Indeed, the reason there is a perceived fiscal crisis in the United States today—along with spending cuts that will further hurt many people—is simple: The banks blew themselves up at great cost to the American people, with major negative global implications. Most of the public-debt increase in the United States and elsewhere is not due to any kind of discretionary fiscal stimulus; it's all about the loss of tax revenue that comes with a deep recession. (The Bush administration's tax cuts for the wealthiest, unfunded Medicare prescription benefit, and debt-financed wars in Afghanistan and Iraq have also severely weakened the long-term fiscal outlook.)

Finally, the cost of the crisis is millions of homes lost and lives damaged, some permanently.

The issue is not whether the Fed, or any central bank, should seek to prevent the collapse of its country's banking system. To see the severe effects of a banking crisis, look no further than the 1930s, a period that Fed Chairman Ben Bernanke has studied in detail. If the choice at any particular moment is to provide support or let the system collapse, you should choose support.

But, more broadly, as Dennis Lockhart, president of the Atlanta Federal Reserve Bank, said at a recent conference organized by his institution, we should not seek to operate a system based on the principle of "private gains and public losses." And these losses are massively skewed in ways that are grossly inefficient, in addition to being completely unfair.

The private gains can be measured most directly in the form of executive compensation. From 2000 to 2008, the people running the top 14 U.S. financial institutions received cash compensation (salary, bonus, and the value of stock sold) of about $2.6 billion. Of this amount, around $2 billion was received by the five best-paid individuals, who were also central to creating the highly risky asset structures that brought the financial system to the edge of the abyss: Sandy Weill (built Citigroup, which blew up shortly after he left) *; Hank Paulson (greatly expanded Goldman Sachs, lobbied for allowing more leverage in investment banks, then became Treasury secretary and helped save them); Angelo Mozilo (built Countrywide, a central player in irresponsible mortgage lending); Dick Fuld (ran Lehman Brothers into the ground); and Jimmy Cayne (ran Bear Stearns into the ground).

The public losses are massive in comparison: roughly $6 trillion, if we limit ourselves just to the increase in federal government debt. And leading bank executives still insist that they should be allowed to run highly leveraged global businesses, in which they are paid based on their return on equity—unadjusted for any risk.

The world's top independent financial minds have looked long and hard at these arrangements, and, given what we have learned in recent years, have found them worse than wanting (for details, see the research of Anat Admati at Stanford's Graduate School of Business). In their view, the big banks should be funded much more with equity—perhaps as much as 30 percent of their capitalization. But bankers strongly reject this approach (because it would likely lower their pay), as do central bankers (because they are too much persuaded by the protestation of bankers).

There are many advantages to having an independent central bank run by professionals who can keep their distance from politicians. But when the people at the apex of these institutions insist that the crisis response went well, and that everything will be fine, even as the financial behemoths that caused the crisis lumber forward, their credibility inevitably suffers. That should worry central bankers, because their credibility is pretty much all they have. The Constitution, after all, does not guarantee the Fed's independence. Congress created the Fed, which means that Congress can un-create it. By assuming away the damage that highly leveraged megabanks can do, the myth of a "good crisis" merely makes political pressure on central banks all the more likely.

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